In this Ropes & Gray podcast, Ama Adams, Brendan Hanifin, and Emerson Siegle discuss recent changes to the Committee on Foreign Investment in the United States (CFIUS) review process and implications for credit funds, including jurisdictional considerations, treatment of contingent equity interests, and risk mitigation strategies.
Emerson Siegle: Hello, and thank you for joining us today on this Ropes & Gray podcast, during which we will be discussing the Committee on Foreign Investment in the United States ("CFIUS") review process and, in particular, CFIUS-related considerations for credit funds. I am Emerson Siegle, a senior associate in Ropes & Gray's Washington, D.C. office. Joining me for today's discussion are Ama Adams, a partner also in our Washington, D.C. office, and Brendan Hanifin, counsel in our Chicago office.
Ama, to orient our listeners, could you please provide a brief overview of CFIUS and its function?
Ama Adams: Sure, Emerson. CFIUS is an interagency committee of the U.S. government with authority to review foreign investments in U.S. businesses that may pose a risk to national security. CFIUS may impose mitigation measures on the parties to a covered transaction—or recommend that the President of the United States block a transaction entirely—if the Committee determines that the foreign investment threatens to impair U.S. national security.
For most transactions, the CFIUS review process is a voluntary filing regime, meaning that the parties to a covered transaction or covered investment are not required to seek CFIUS pre-clearance before proceeding with the transaction. Although the process is (largely) voluntary, failure to notify CFIUS of a covered transaction or covered investment can result in significant risk where meaningful national security issues are involved. For the subset of investments subject to a mandatory filing requirement, failure to file may result in a penalty up to the value of the transaction. Historically, CFIUS's jurisdiction was limited to transactions in which a foreign person makes an investment that could result in control of a U.S. business. Here, it is important to note that the CFIUS regulations generally do not define "control" in terms of a specified percentage of ownership interest or number of board seats. Under CFIUS regulations, "control" is defined more broadly than in the corporate context, and means "the power, direct or indirect, whether or not exercised," to determine or prevent key matters, such as major expenditures or investments, appointment or dismissal of key officers, business strategy, approval of the annual budget, and others. As Brendan will describe in a moment, recently implemented changes to the CFIUS regulations have expanded the Committee's jurisdiction to non-controlling investments in certain categories of U.S. businesses. As a result of these changes, certain investments that historically were outside the scope of CFIUS's jurisdiction may now be potentially subject to CFIUS review.
Brendan Hanifin: In 2018, Congress passed and President Trump signed the Foreign Investment Risk Review Modernization Act ("FIRRMA"), which expanded CFIUS's authority in a number of key ways. First, as Ama alluded to, FIRRMA expanded CFIUS's jurisdiction to include certain non-passive, non-controlling investments, called "covered investments," in three categories of U.S. businesses: companies that produce, design, test, manufacture, fabricate, or develop one or more critical technologies; companies that own, operate, manufacture, service, or supply critical infrastructure; and companies that collect or maintain sensitive data of U.S. citizens. Collectively, these categories of U.S. businesses are now referred to as "TID U.S. businesses," standing for technology, infrastructure, and data. Second, FIRRMA introduced a mandatory filing requirement for certain investments in critical technology companies, as well as certain "substantial" investments in TID U.S. businesses by foreign government-affiliated investors. Third, FIRRMA clarified the treatment of non-U.S. limited partners who invest in U.S. businesses indirectly via a pooled investment fund. This clarification is commonly referred to as the "investment fund exception."
For CFIUS's expanded jurisdiction over non-controlling investments in TID U.S. businesses to be triggered, the investment must result in a foreign person acquiring:
- board member or observer rights;
- access to material nonpublic technical information in the possession of the TID U.S. business; or
- involvement in substantive decision-making of the TID U.S. business (which is defined to include involvement in decision-making regarding specific contracts, corporate strategy and business development, research and development, critical technology, critical infrastructure, and sensitive personal data).
Emerson Siegle: Brendan, you mentioned an exemption for investment funds. How does that exemption work in practice?
Brendan Hanifin: The new CFIUS regulations, which went into effect in February of this year, clarified that an indirect investment by a foreign person in a TID U.S. business through a pooled investment fund will not automatically trigger CFIUS jurisdiction, even where the foreign investor is represented on the advisory board (or equivalent) of the fund. For the exemption to apply, several specific requirements must be met:
- the fund must be managed exclusively by a general partner, managing member, or equivalent that is not deemed a foreign person;
- the advisory committee must not have control over investment decisions of the fund, or of the general partner more generally; and
- the foreign person must not otherwise have control over the fund, or one of the specified non-controlling rights for "covered investments," such as access to material nonpublic technical information of the TID U.S. business.
Emerson Siegle: There are three threshold questions that sponsors should consider in assessing whether the CFIUS regulations may be relevant to their investments.
The first question is: would the fund be considered a "foreign person" as broadly defined for CFIUS purposes? Somewhat counterintuitively, this analysis needs to be undertaken at both the fund and the limited partner levels. As an initial matter, if a fund is organized outside the United States (such as in the Cayman Islands), in most cases, the fund would be deemed a "foreign person," if the fund's principal place of business is located outside of the United States as well. In this context, principal place of business means the place where the fund's activities and investments are primarily directed, controlled, or coordinated by or on behalf of the general partner, managing member, or equivalent. Notably, if a fund has declared a non-U.S. principal place of business in a recent government filing (such as for tax purposes), the fund would be presumed to have a non-U.S. principal place of business for CFIUS purposes as well. The definition of foreign person also encompasses any entity—regardless of country of organization—over which control is exercised or exercisable by a foreign national, foreign government, or foreign entity. Therefore, assuming the fund is not itself a foreign entity, the next question is whether the fund qualifies as foreign because a foreign person is able to exercise control over it. As mentioned earlier in the discussion, the CFIUS regulations define "control" very broadly. While the ability to cause or prevent investment decisions would be sufficient to support a finding of foreign control, control over investment decisions is not a prerequisite for CFIUS jurisdiction. Foreign control could also exist where a foreign person (such as a founder, manager, or non-U.S. limited partner) has the ability to cause or prevent key decisions affecting the fund (whether by LP interest, effective control of the LPAC, or otherwise). Such key decisions include, among others: removal of the general partner; dissolution of the partnership; amendment of the limited partnership agreement; the admission of new LPs; or incurrence of significant indebtedness. To determine whether a fund is "controllable" by a foreign person, it is generally necessary to review the fund structure, as well as the limited partnership agreement. Control rights also can be contained in side letters with anchor limited partners, although this is less common in practice.
The second and related question is: does the participation of any foreign limited partner trigger CFIUS's jurisdiction, or does the investment fund exception apply? On this point, it is worth noting that the investment fund exception is relatively new, and there are still some open questions about its interpretation. For example, application of the indirect investment fund exception to separately managed accounts ("SMAs"), funds-of-one, and funds-of-a-few limited partners is unknown. Such arrangements generally are perceived as providing the limited partner or partners more control than in the typical GP/LP construct. In addition, the transaction documents establishing SMAs or funds-of-one commonly will afford certain approval rights to the limited partner—such as around winding up of the relationship or admission of new limited partners—that are sufficient to support a finding of control (as broadly defined for CFIUS purposes). Although the Committee has not squarely addressed this issue, many practitioners believe that CFIUS could conclude that an SMA or fund-of-one does not qualify for the indirect investment fund exception.
And finally, the third question is: Is the fund making investments of the sort that would be subject to CFIUS's jurisdiction? On this last point, Brendan, would you discuss how CFIUS applies differently to lending transactions and debt investments, as compared to more traditional equity investments?
Brendan Hanifin: In general, lending transactions are not within the scope of CFIUS's jurisdiction, provided that they do not grant a foreign person economic or governance rights more characteristic of an equity investment. If a financing or lending transaction grants a foreign party certain rights, such as an interest in profits of a U.S. business; the right to appoint members to the board of directors of the U.S. business; or other comparable financial or governance rights characteristic of an equity investment, CFIUS could have jurisdiction over the transaction.
Where a foreign party acquires a convertible debt instrument that will confer equity-like rights upon conversion, the CFIUS jurisdictional analysis becomes fact-specific. In particular, acquisition of a contingent equity interest can trigger jurisdiction either at the time of acquisition; or upon conversion, depending on the circumstances. CFIUS may consider the acquisition of a contingent equity interest to be within its jurisdiction—as opposed to just the exercise of that interest—under the following circumstances:
- first, if the conversion is imminent;
- second, whether the conversion is dependent on factors within the control of the party acquiring the contingent interest; and
- third, whether the amount of interest and the rights that would be acquired upon conversion can be reasonably determined at the time of acquisition.
Emerson Siegle: It also bears mentioning that, even where an initial lending transaction is not subject to CFIUS jurisdiction, jurisdiction could be triggered at a later time. For example, jurisdiction can be triggered where, as the result of imminent or actual default, there is a significant possibility that a foreign person may acquire control, or one of the qualifying, non-control rights for "covered investments" in TID U.S. businesses.
Ama Adams: Many of these considerations are potentially relevant to credit funds, including funds that, at least on their face, appear to be U.S. funds because they are managed by a U.S.-based sponsor. As Emerson described, investments can be within the scope of CFIUS's jurisdiction even if the fund is managed by a U.S. sponsor, whether by virtue of the fund's place of incorporation and principal place of business, or due to the rights that non-U.S. investment personnel or non-U.S. limited partners may possess with respect to the fund's activities. In addition, for each new fund, sponsors would be well served to consider whether the funds' contemplated investment activities are likely to present material CFIUS risk. For example, for a fund that intends to make purely passive debt investments in lower risk businesses, CFIUS is less likely to be a material consideration. By contrast, for a fund that intends to make contingent equity investments—or debt investments that carry equity-like rights—it may be appropriate to perform at least an initial CFIUS assessment of each new investment opportunity. In addition, because transaction-specific considerations—such as the involvement of non-U.S. co-investors in a portfolio investment—generally cannot be anticipated in advance, a CFIUS analysis conducted at the fund level, at the time of fundraising, likely will not account for the entire universe of transactions for which CFIUS may be relevant.
Brendan Hanifin: Emerson, performing an investment-by-investment CFIUS analysis sounds burdensome. In addition, it may not be practical for investments in distressed businesses, where credit funds need to act quickly, or risk losing the opportunity. Aside from performing the initial jurisdictional analysis at the fund level, can CFIUS risk be mitigated through representations and warranties?
Emerson Siegle: The good news is that it will be rare—although not impossible—for a credit investment to trigger a mandatory CFIUS filing requirement. Currently, CFIUS's mandatory filing jurisdiction applies only in two circumstances: Certain non-passive investments by foreign persons in "critical technology" companies; and certain, "substantial" investments by foreign government-affiliated investors in TID U.S. businesses. As such, even if CFIUS jurisdiction were somehow triggered—such as due to a parallel investment by a non-U.S. LP—it is very unlikely that a mandatory filing would be in play.
As to representations and warranties, it is becoming increasingly common for sponsors to seek to manage CFIUS risk through a combination of provisions in the Limited Partnership Agreement as well as in the Subscription Documents:
- For the Limited Partnership Agreement, common provisions include: a provision indicating that the General Partner has, notwithstanding anything else to the contrary in the transactional documents, the ability to manage the fund to mitigate CFIUS risk; a provision requiring that Limited Partners comply with informational and other requests, including if CFIUS initiates a review of a transaction; and provisions with respect to indemnification or other allocation of risk if the CFIUS-related representations provided by limited partners are not accurate.
- And for the Subscription Documents, sponsors increasingly are seeking foreign person representations on behalf of limited partners, as well as disclosure of foreign government ownership interests.
In general, these provisions are intended to give the General Partner and the Fund as much information as possible about potential CFIUS-related risks, and to give the General Partner and the Fund as much flexibility as possible in addressing those concerns.
Brendan Hanifin: On that point, our experience has been that CFIUS-related provisions can be subject to heavy negotiation, largely because they are a relatively novel concept and each sponsor and fund presents a different CFIUS risk profile. In some cases, sponsors may determine that the added time and expense of seeking CFIUS-related provisions in the limited partnership agreement or subscription document is not worth the corresponding benefit. In other cases, such protections may be invaluable to the sponsor, particularly if the fund is comprised of an array of foreign limited partners whose CFIUS sophistication and risk tolerance is varied.
Emerson Siegle: Thank you, Ama and Brendan, for joining me today for this discussion. And thank you to our listeners. For more information regarding the topics discussed today, as well as links to our recent client alerts and analyses, please visit Ropes' Committee on Foreign Investment in the United States practice page at www.ropesgray.com. If we can help you to navigate these issues, please do not hesitate to contact us. You can also subscribe and listen to this series wherever you regularly listen to podcasts, including on Apple, Google or Spotify. Thanks again for listening.
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